How an energy crisis became an economic and political crisis too.

BY COLIN COOKMAN|MAY 10, 2012

Over the course of its four years in office, the embattled government of Pakistani Prime Minister Yousuf Raza Gilani has weathered challenges from opposition parties both new and old, threats of military intervention or coup, and most recently, a conviction sentence from Pakistan's iconoclastic judiciary for its unwillingness to seek the reopening of corruption charges against President Asif Ali Zardari -- which may eventually lead to Gilani's disqualification from office. Although the government has shown remarkable tenacity in the face of these challenges, its fights for political survival -- taking place as relations with Pakistan's principal sponsor, the United States, have plummeted -- have obscured the worsening state of the country's economic health at home.

Pakistani leaders have, of course, long grappled with mounting debt obligations, chronic revenue shortages, and a persistent power crisis that threatens Pakistan's ability to meet its growing population's need for energy and sustained economic growth. But a new warning sign came this week when nine of the country's independent power producers invoked charges of sovereign default against the government, saying they would pursue legal suits unless they received approximately $375 million in outstanding dues, dating back to last fall, before week's end. These producers have used such brinkmanship tactics in the past to force government action, and officials are now scrambling to take out new loans to make the payments. Even if this latest challenge is resolved at the eleventh hour, however, the cumulative trend is clear: Pakistan can't keep the lights on.

Demand for energy in Pakistan now outstrips its capacity to supply electricity to industry and households by several thousand megawatts. With preliminary census projections of a population of more than 192 million and the share of the urban population rising, the challenge to power Pakistan will only grow more difficult. Already, hours-long interruptions in power have dragged down productivity in key sectors like the textile industry and sparked confrontations between rural and urban political leaders and the transportation, agricultural, and manufacturing sectors for priority access to what energy is produced.

These gaps in capacity are compounded by the "circular debt" crisis facing the power sector, which lies at the heart of this week's charges. The short version -- without attempting to untangle at length the complicated networks of government-managed and private energy suppliers, generators, and distributors involved -- of the circular-debt story is that Pakistani government regulators have habitually set end-consumer energy prices below the cost of production. But the government's inability to keep up with its pledges to make subsidy payments has left the power sector struggling and trapped in this cycle of interconnected debts.

Those difficulties have been further exacerbated by theft, leakage, and weak collections, including from the government, which routinely can't even pay its own electricity bills, let alone the subsidies. As these dues go unpaid, distribution companies are unable to repay their debts to generators for the purchase of energy, which are in turn unable to repay debts to suppliers for the purchase of the oil or natural gas by which energy is produced.

The energy crisis has been bubbling underneath the surface of Pakistan politics for several years now. Efforts to gradually bring subsidized prices more in line with actual costs inevitably draw widespread protests from those most affected and have on occasion cost the government the support of groups like the Muttahida Quami Movement -- a key swing bloc in national ruling coalitions with a strong political hold over the country's largest city, Karachi -- forcing a rollback. Last November, the government attempted to resolve the issue by assuming responsibility for approximately $3.4 billion in power-sector circular debt, transforming it into sovereign debt and borrowing heavily to do so. Private debts among producers, suppliers, and distributors have continued to mount, however, and the fundamental disconnect that drives circular debts in the power sector remains unresolved.

These nine independent power producers -- which collectively produce 8 to 9 percent of Pakistan's energy supply -- now warn that they can no longer continue operations if government payment is not immediately forthcoming. With fresh borrowing plans, the government is likely to negotiate another settlement with these companies. But the overall state of the power industry offers few incentives for large-scale investment, with grim implications for efforts to increase production capacity.

Here again, Pakistan's tangled politics are forestalling solutions. The Pakistan People's Party government's efforts to preserve the broadest coalition of supporters possible to guard against its many rivals have hampered its ability to advance serious structural reforms -- such as the removal of exemptions on politically powerful sectors such as those on agricultural income -- that could close the budget gap and allow it to make good on its subsidy pledges. At approximately 9 percent of GDP, Pakistan has one of the lowest rates of tax revenue collection in the region (though the exact calculation has been called into doubt thanks to a back-and-forth dispute between statistics officials and the Finance Ministry over the exact size of the economy itself). Pakistan's debt crisis is significant and growing; approximately half of this year's federal budget expenditures were devoted to debt repayment, far eclipsing military spending, government salaries, or development investments.

Prior to the power-sector default, the IMF had projected that Pakistan would need to refinance the equivalent of 30 percent of its GDP this year to cover maturing debt and budget deficits; with this additional blow to its creditworthiness, borrowing costs are likely to increase in the future. Buoyed by approximately $16.4 billion in foreign currency reserves, cushioned by several years of high remittance flows from Pakistanis living abroad, Pakistani finance officials have expressed confidence in their ability to remain in good standing on external debt repayment obligations; the most recent World Bank figures from 2010, however, estimate that its reserves amount to only 4.7 months' worth of imports.

As foreign lenders turn leery, the government over the past year has turned to domestic sources, becoming the country's largest borrower and amassing domestic debts equivalent to approximately 38 percent of GDP as of December 2011 (total debts exceed 62 percent of GDP). To date, Pakistani banks have shown willingness to continue purchasing government treasury bonds -- judging them a safer bet than nonperforming private-sector loans -- but the country's central bank has repeatedly warned that government borrowing is crowding out other potential borrowers from domestic sources of credit, choking off the country's growth. Again, the story here only gets grimmer: More than half of Pakistan's domestic debt is in the form of short-term loans that must be rolled over with new financing at least once per year -- the costs of which may now increase.

For all the focus on Islamic militancy and drone strikes, it is the mounting energy and debt crises that may present the most serious threat to Pakistan's future, bringing not only severe pain to Pakistani citizens in the near term but also preventing them from investing effectively in their future. With a history of coups and extraconstitutional transfers of power, Pakistani political leaders have limited experience with being held publicly accountable for their management of the country's economic development. But the prospects for Pakistan's democracy and long-term stability will ultimately depend on it.